FIN 683
Financial Institutions Management
The Specialness of Banks
Professor Robert B.H. Hauswald
Kogod School of Business, AU
Alternative Views on the Financial System
“Increasingly complex financial instruments have
contributed to the
development of a far more flexible, efficient and
hence resilient financial system than the one that
existed a quarter century ago.”
- Alan Greenspan, November 2005
“The bright new financial system – for all its rich
rewards and unimaginable wealth for some – has
failed the test of the marketplace by repeatedly
risking
a cascading breakdown of the system as a
whole.”
- Paul Volcker, April 2008
1/19/2016
Bank Specialness
© Robert B.H. Hauswald
2
Bank Losses and Credit Crunch
• Credit crunch: contraction in the supply of credit
– a contraction in the supply funds in a market
• Who is contracting their supply of credit?
– Banks because of losses that initially stemmed from
the subprime mortgage market
• Losses spread to other credit markets
– Commercial real estate loans
– Leverage loans
– Other subprime consumer loans
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Bank Specialness
© Robert B.H. Hauswald
3
Financial System Architecture
• Financial institutions’ profits “outsized”
– i.e., they exceed value added
• The model interrupted: the “credit” crunch
• A crunch can involve multiple markets
–
–
–
–
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US: 1990 to 1992
Scandinavia: 1991 to 1994
Japan: 1992 to 2000
US: 2008 to 2010
Bank Specialness
© Robert B.H. Hauswald
4
Financial System Architecture:
Normal Flow of Funds
Financial
Intermediaries
$
$
Saver/
Investors
$
$
Business
$
Securities
Markets
$
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Bank Specialness
$
Consumers
$
$
© Robert B.H. Hauswald
5
Financial System Architecture:
Credit Squeeze or Crunch A “CRUNCH”
Financial
Intermediaries
$
$
Saver/
Investors
$
1/19/2016
$
Business
$
Securities
Markets
$
Bank Specialness
$
Consumers
$
$
© Robert B.H. Hauswald
6
Financial System Profits: Outsized
1980s
2007
Percent of gross domestic value-added
8%
15%
Percent of private sector employment
4%
5%
Percent of stock market capitalization
6%
19%
10%
40%
Percent of corporate profits
Continued financial sector growth even after the fundamentals
weakened or fell away.
What about executive compesation?
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Bank Specialness
© Robert B.H. Hauswald
7
Finance Sector Profit & Gross Value-Added
(% of total corporate)
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Bank Specialness
© Robert B.H. Hauswald
8
Credit-Crunch Evidence
• Bank liquidity creation fell dramatically
– predates inception of banking crisis (April or August 2007)
• Fed’s Senior Loan Officer Survey began showing
“tightening” loan standards in 2006
– Index turned negative in early 2007 (net negative response by
lenders) escalating in third quarter
– The net percentage of large and medium-sized banks, and the
net percentage of small banks, that reported a tightening of
standards was 55.4% and 51.8% respectively.
– None of the surveyed banks reported any easing of standards.
– Comparable to prior to comparable crunches in 1990 or 2001
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Bank Specialness
© Robert B.H. Hauswald
9
Liquidity Contraction:
(Liquidity = Liquidity Transformation)
Abnormal amount of liquidity creation around 1990 credit crunch
(1990:Q1 – 1992:Q4) (in $ billion)
Source: “Financial Crisis and Bank Liquidity Creation,” Allen N. Berger and Christa H.S. Bouwman,
University of South Carolina working paper(August 2008).
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Bank Specialness
© Robert B.H. Hauswald
10
Liquidity Contraction:
(Liquidity = Liquidity Transformation)
Abnormal amount of liquidity creation around the dot.com bubble
and the Sept. 11 terrorist attack
(2000:Q2 – 2002:Q3) (in $billions)
Source: “Financial Crisis and Bank Liquidity Creation,” Allen N. Berger and Christa H.S. Bouwman,
University of South Carolina working paper(August 2008).
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Bank Specialness
© Robert B.H. Hauswald
11
Liquidity Contraction:
(Liquidity = Liquidity Transformation)
Abnormal amount of liquidity creation in today’s crisis
(2007:Q3 – 2008:Q1) (in $billions)
Source: “Financial Crisis and Bank Liquidity Creation,” Allen N. Berger and Christa H.S. Bouwman,
University of South Carolina working paper(August 2008).
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Bank Specialness
© Robert B.H. Hauswald
12
Financial Market1992-2008 (Liquidity = Trading Liquidity)
(a)
Sources: Bank of England, Bloomberg, Chicago Board Options Exchange, Debt Management Office, London Stock Exchange, Merrill Lynch, Thomson
Datastream and Bank calculations (see Bank of England Financial Stability Report (April 2008).
(a) The liquidity index shows the number of standard deviations from the mean. It is a simple unweighted average of nine liquidity measures, normalised on the
period 1999–2004. The series shown is an exponentially weighted moving average. The indicator is more reliable after 1997 as it is based on a greater number of
underlying measures.
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Bank Specialness
© Robert B.H. Hauswald
13
Spillovers to Other Markets
• Bank loan market: interbank market
• Commercial paper market
– Traditional
– Asset-backed
• Residential and commercial mortgage markets
• Consumer loan market
– Prime
– Subprime
• Junk bond market
• Private placement market
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Bank Specialness
© Robert B.H. Hauswald
14
Credit Squeeze Example:
U.S. SME Market
o = open “lending channel”
x = constricted “lending channel”
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Bank Specialness
© Robert B.H. Hauswald
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Credit Squeeze Example:
Japanese SME Market, 1990-2000
o = open “lending channel”
x = constricted “lending channel”
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Bank Specialness
© Robert B.H. Hauswald
16
Current Credit Squeeze:
U.S. SME Market
o = open “lending channel”
x = constricted “lending channel”
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Bank Specialness
© Robert B.H. Hauswald
17
Credit-Crunch Causes
• Banks suffer a shock that affects their ability
and/or incentive to lend
• Many types of potential shocks: historical
shocks include, for example:
–
–
–
–
Capital shock (US 1990-92, Japan 1990-2000)
Regulatory reporting shock (US 1990-92)
Regulatory scrutiny shock (US 1990-92)
Risk-based capital shock (US 1990-92)
• Currently: “capital shock” caused initially by
losses in the Bank
subprime
mortgage market
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Specialness © Robert B.H. Hauswald
18
Capital-Shock Mechanics
• Banks must meet required capital
requirements (e.g, S.E./T.A. > 8%)
• Banks have target capital requirements driven
by reputation/credibility effects
• Losses deplete capital, i.e., shareholder equity
• Banks must either
– Raise more equity: e.g., sovereign wealth funds
– Reduce assets by contracting lending: balance
sheet shrinks
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Bank Specialness
© Robert B.H. Hauswald
19
Banking in the News
February 29, 2008, 11:59 am, WSJ
Banks May Need to Shrink by $2 Trillion on Subprime Losses
Mortgage losses, compounded by contemporary risk management and
accounting practices could prompt banks and other lenders to shrink their
lending and other assets by a staggering $2 trillion, a new study concludes.
The resulting withdrawal of credit could knock one to 1.5 percentage points
off economic growth, significantly compounding the impact of collapsing
home construction and softer consumer spending due to lower home wealth,
the study, presented at a joint academic-Wall Street forum in New York Friday.
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Bank Specialness
© Robert B.H. Hauswald
20
BIG BANK
Securities
300
Deposits
Loans
700
S.E.
TA
1,000
920
80
TL&SE
1,000
SE/TA =8%
BIG BANK
Bank charges off
$10 in loan losses
Securities
300
Deposits
Loans
690
S.E.
TA
990
300
Deposits
Loans
575
S.E.
TA
875
TL&SE
SE/TA = 8%
70
TL&SE
990
SE/TA = 7.07%
BIG BANK
Securities
920
805
70
875
Bank reduces loans by
$115
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Bank Specialness
© Robert B.H. Hauswald
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Bank Specialness
© Robert B.H. Hauswald
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WSJ 3/4/08
22
Economist (August 9-15, 2008)
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WSJ 1/18/08
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© Robert B.H. Hauswald
23
Financial Intermediaries are
Special
• Special role of FIs in the financial system and
the functions they provide
– FIs receive special regulatory attention
– Some FIs more special than others
• Put the recent/current financial crisis into
perspective
– consequences: credit crunch
– origins: revisited later
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Bank Specialness
© Robert B.H. Hauswald
Without FIs
Households
Equity &
Debt
(net savers)
Corporations
(net borrowers)
Cash
1-25
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Bank Specialness
© Robert B.H. Hauswald
FIs’ Specialness
• Without FIs: Low level of fund flows.
– no aggregation: transaction costs
– no scale economies in screening, monitoring, etc.
• Information costs
– Economies of scale reduce costs for FIs to screen
and monitor borrowers
• Less liquidity
• Substantial price risk
1-26
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Bank Specialness
© Robert B.H. Hauswald
With FIs
FI
(Brokers)
Households
Cash
FI
Deposits/Insurance
Policies
1-27
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Corporations
Equity & Debt
(Asset
Transformers)
Bank Specialness
Cash
© Robert B.H. Hauswald
Brokerage Functions
• Acting as an agent for investors:
– e.g. Merrill Lynch, Bank of America
– Reduce costs through economies of scale
– Encourages higher rate of savings
• Asset transformer:
– Purchase primary securities by selling financial
claims to households
– These secondary securities often more marketable
– Transformation of financial risk
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Bank Specialness
© Robert B.H. Hauswald
Role of FIs in Cost Reduction
• Investors exposed to Agency Costs
– asymmetric information + conflict of interest
• Role of FI as Delegated Monitor
– FI likely to have informational advantage
– Economies of scale in obtaining information.
• FI as an information producer
– Shorter term debt contracts easier to monitor than bonds
– Greater monitoring power and control
– Acting as delegated monitor, FIs reduce information
asymmetry between borrowers and lenders
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Bank Specialness
© Robert B.H. Hauswald
Specialness of FIs
• FI have an advantage in assuming certain risks
– Liquidity and Price Risk: why?
• Secondary claims issued by FIs have less price
risk
• Demand deposits and other claims are more
liquid
– More attractive to small investors
• FIs have advantage in diversifying risks
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Bank Specialness
© Robert B.H. Hauswald
Other Special Services
•
•
•
•
Reduced transactions costs
Maturity intermediation
Transmission of monetary policy.
Credit allocation (areas of special need such as
home mortgages)
• Intergenerational transfers or time intermediation
• Payment services (FedWire and CHIPS)
• Denomination intermediation
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Bank Specialness
© Robert B.H. Hauswald
Specialness and Regulation
• FIs receive special regulatory attention.
• Rationale: banks provide externalities
– Positive externalities: services, information
– Negative externalities of FI failure
• Special services provided by Fis: vital
• Institution-specific functions such as
– money supply transmission (banks),
– credit allocation (thrifts, farm banks),
– payment services (banks, thrifts), etc.
1-32
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Bank Specialness
© Robert B.H. Hauswald
Regulation of FIs
• Objective of regulatory policy:
– Protect ultimate sources and users of savings
– Including prevention of unfair practices such as
redlining and other discriminatory actions
• Primary role: Ensure soundness of the
overall system
• Goes hand in hand with supervision
– is banking the most regulated/supervised sector?
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Bank Specialness
© Robert B.H. Hauswald
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Regulation
• Safety and soundness regulation:
– targeted at individual institutions
– protect depositors
• Regulations to increase diversification
– No more than 10% of equity to single borrower
• Minimum capital requirements
– TARP and Capital Purchase Program
• Systemic soundness
– like the military, always fighting the last crisis
1-34
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Bank Specialness
© Robert B.H. Hauswald
Fragmented Regulation
• Guaranty funds:
– Deposit insurance fund (DIF):
– Securities Investors Protection Fund (SIPC)
• Monitoring and surveillance:
– FDIC monitors and regulates DIF participants
– Increased regulatory scrutiny following crises
• Regulation is not costless
– Net regulatory burden
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Bank Specialness
© Robert B.H. Hauswald
Web Resources
• For information on regulation of DIs and
investment firms visit:
FDIC www.fdic.gov
SIPC www.sipc.org
Federal Reserve www.federalreserve.gov
Appendix 1B of text
www.mhhe.com/saunders7e
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Bank Specialness
© Robert B.H. Hauswald
Monetary Policy
• Federal Reserve directly controls outside money
• Bulk of money supply is inside money: deposits
• Reserve requirements facilitate transmission of
monetary policy
• Explains the heavy involvement of the FRB in
regulating banks
– expertise
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Bank Specialness
© Robert B.H. Hauswald
Credit Allocation Regulation
• Supports socially important sectors such as
housing and farming
– political rather than economic reasons
• Requirements for
– minimum asset amounts in a particular sector or
– maximum interest rates or fees
• Qualified Thrift Lender Test (QTL)
– 65 percent of assets in residential mortgages
• Usury laws and Regulation Q (abolished)
1-38
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Bank Specialness
© Robert B.H. Hauswald
Consumer Protection
• Consumer protection regulation
– Community Reinvestment Act (CRA)
– Home Mortgage Disclosure Act (HMDA)
• Effect on net regulatory burden
– FFIEC processed info on as many as 17 million
mortgage transactions in 2009
– Analysts questioning the net benefit
1-39
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Bank Specialness
© Robert B.H. Hauswald
Consumer Protection Regulation
• Potential extensions of regulations
– CRA to other FIs such as insurance companies
in light of consolidation and trend toward
universal banking
• New additions:
– Consumer Financial Protection Agency (2009)
– Credit card reform bill effective 2010
1-40
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Bank Specialness
© Robert B.H. Hauswald
Investor Protection
• Regulation against abuses such as
– insider trading,
– lack of disclosure,
– malfeasance, breach of fiduciary responsibility
• Key legislation
– Securities Acts of 1933, 1934
– Investment Company Act of 1940
• Primary regulator: SEC
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Bank Specialness
© Robert B.H. Hauswald
Entry
• Entry regulation: fragmentation
– changed in 1933: state banking
– unsustainable: inter-state branching
• Level of entry impediments affects profitability
and value of charter.
• Regulations define scope of permitted activities
– Financial Services Modernization Act of 1999
• Affects charter value and size of net regulatory
burden
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Bank Specialness
© Robert B.H. Hauswald
Web Resources
•
For more information on regulation of
depository institutions visit:
FFIEC www.ffiec.gov
Federal Reserve www.federalreserve.gov
FDIC www.fdic.gov
OCC www.occ.treas.gov
1-43
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Bank Specialness
© Robert B.H. Hauswald
Changing Dynamics of
Specialness
• Decline in share of depository institutions
and insurance companies
• Increases in investment companies
• May be attributable to net regulatory burden
imposed on depository FIs
– Financial Services Modernization Act
• Financial services holding companies
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Bank Specialness
© Robert B.H. Hauswald
Risk and the Financial Crisis
• Reactions to FSM Act and other factors:
– more competition between banks and markets
– banks became hedge funds
• Shift from “originate and hold” to “originate
and distribute”
– Affects incentives to monitor and control risk.
– Shift to off balance sheet risks
– Degraded quality and increased risk
• Housing market bubble encouraged
– subprime market and more exotic mortgages
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Bank Specialness
© Robert B.H. Hauswald
Global Trends
• US FIs facing increased competition from
foreign FIs
• Only 2 of the top ten banks are US banks
• Foreign bank assets in the US typically
more than 10 percent
– As high as 21.9 percent
• Emerging-market banks are becoming
important: BRICS
1-46
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Bank Specialness
© Robert B.H. Hauswald
Largest Banks
1-47
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© Robert B.H. Hauswald
Financial Crisis
• DJIA fell 53.8 percent in less than 1 ½ years
as of mid-March 2009
• Record home foreclosures
– 1 in 45 in default in late 2008
• Goldman Sachs and Morgan Stanley
– only survivors of the major WS houses
– became “banks”
1-48
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Bank Specialness
© Robert B.H. Hauswald
Financial Crisis
• AIG bailout
• Citigroup needed government support
• Many other banks applied for and received
government guarantees
• Chrysler and GM declared bankruptcy in 2009
• Unemployment in excess of 10 percent
• Unprecedented liquidity injections by Fed
– consequence? costs?
1-49
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Bank Specialness
© Robert B.H. Hauswald
Beginning of the Collapse
• Home prices plummeted in 2006-07
– Mortgage delinquencies rose
– Forelosure filings increased 93 percent from
July 2006 to July 2007
• Securitized mortgages led to large financial
losses
– Subprime mortgages
• Countrywide Financial bailed out and
eventually taken over by Bank of America
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Bank Specialness
© Robert B.H. Hauswald
Significant Failures and Events
• Bear Stearns funds filed for bankruptcy
– Acquired by J.P. Morgan Chase
– Fed moved beyond lending only to Depository
Institutions
• Government seizure of Fannie Mae and
Freddie Mac
• Lehman Brothers failure
• Crisis spread worldwide
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Bank Specialness
© Robert B.H. Hauswald
Rescue Plan
• Federal Reserve and other central banks
infused $180 billion
• $700 billion Troubled Asset Relief Program
(TARP)
• Still struggling in 2009
• $827 billion stimulus program
– American Recovery and Reinvestment Act of
2009
1-52
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Bank Specialness
© Robert B.H. Hauswald
Conclusion
• Banks exist for many economic reasons:
– there is no unique view, nor a unified theory
• Apart from transaction costs, the main
reasons why financial intermediaries exist are
– intertemporal insurance
– screening
– monitoring
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Bank Specialness
© Robert B.H. Hauswald
Pertinent Websites
The Banker
Federal Reserve
FDIC
FFIEC
Investment Co. Institute
OCC
SEC
SIPC
Wall Street Journal
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Bank Specialness
www.thebanker.com
www.federalreserve.gov
www.fdic.gov
www.ffiec.gov
www.ici.com
www.occ.treas.gov
www.sec.gov
www.sipc.org
www.wsj.com
© Robert B.H. Hauswald
53
When FIs Fail: Subprime Mortgages
• FIs involved both as brokers and asset transformers
• Packaged and sold mortgage-backed securities
(MBS) and collateralized debt obligations (CDOs)
– Many MBS’s had subprime mortgages
– Many CDO’s bought subprime mortgage MBS’s
• Invested in directly and indirectly in MBS and
CDOs – asset-transformers
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Bank Specialness
© Robert B.H. Hauswald
55
Subprime
• A subprime mortgage has lower
underwriting standards
• Low “credit score” (e.g., a FICO score
below 650)
• No documentation (Lo Doc): no income
verification
• Loan/value ratio > 80%
• Also, often have “teaser” rates
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Bank Specialness
© Robert B.H. Hauswald
56
Asset Backed Securities
• MBS: security back by mortgages
– a “trust” that owns mortgages and issues securities
to investors
– Can be engineered artificially to segment risk: .,
defaults first go to the riskier traunches
• CDO: bond issued by a trust that owns fixed
income debt obligations (or derivatives).
– the problem CDOs have invested in subprime MBS
– Can be engineered to segment risk: Possibly double
engineered!
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© Robert B.H. Hauswald
57
The Perfect Storm
• What is the problem?
– Housing prices have been falling
– Record number of defaults and foreclosures
– Subprime most affected
• What happened to the securities?
• What happened to the financial institutions
which bought subprime paper?
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© Robert B.H. Hauswald
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Who’s Fault?
• Rating agencies looked only at recent MBS
payment performance
• Many “originators” immediately sold
mortgages
– Insufficient screening and monitoring incentives
– Incentive to encourage home buyers to buy too
much house
– Predatory lending
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© Robert B.H. Hauswald
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Greed and Fear
• Banks made lots of money creating MBS’s and
CDO’s (100-150 bps)
– These “packagers” lacked incentives to screen and
monitor
• Mostly an unregulated market
– Fed examiners only saw narrow picture
• Some homebuyers may have been imprudent
– Wanted to “keep up with the neighbors”
– Wanted to cash in on hot real estate market
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Bank Specialness
© Robert B.H. Hauswald
60
Housing Sales Decline and
InventoriesInventory
Riseof Unsold Homes
Single-family Home Sales
(months supply)
(thousands)
1600
6400
This image cannot currently be display ed.
Existing
Existing homes
1400
5600
1200
4800
1000
New
4000
800
600
2003
New homes
3200
2400
'04
'05
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'06
'07
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© Robert B.H. Hauswald
61
Housing Prices Fell …
Home price index change
(percent change over prior year)
Case-Shiller Home Price Index
20
15
10
5
OFHEO price index
0
-5
'75
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'80
'85
'90
Bank Specialness
'95
© Robert B.H. Hauswald
2000
'05
62
… with Larger Declines in Some
Markets
Case-Shiller Home Price Index
(percent change over prior year)
50
40
30
Miami
20
Phoenix
10
San Diego
National
0
'88
'90
'92
'94
'96
'98
'00
'02
'04
'06
-10
-20
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© Robert B.H. Hauswald
63
Subprime Mortgage Backed
Securities Issuance
$600
24%
$450
18%
billions
← $ volume (billions)
$300
12%
% of total mortgage originations →
$150
6%
$0
0%
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Source: Inside Mortgage Finance, “The 2007 Mortgage Market Statistical Annual”
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© Robert B.H. Hauswald
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